Rule against Penalties relaxed

An important decision of the Supreme Court has made it less likely that spurious challenges to asset financiers’ liquidated damages clauses will succeed.

For many years now there have been numerous challenges to liquidated damages clauses based on the common law rule against penalties, which in essence has been understood to provide that in order to be effective a liquidated damages clause must only provide for a genuine pre-estimate of the financier’s loss – otherwise it will be struck down as a “penalty” on the grounds of public policy.

Financiers have been careful to avoid a damaging precedent being set in a reported decision of the higher courts, but almost all asset financiers will have experience of being met with resistance to liquidated damages clauses on these grounds.

This area of law was ripe for review by the highest court, so a panel of seven judges sat in the combined appeals of Cavendish Square Holding BV v Makdessi and ParkingEye Ltd v Beavis (Consumers’ Association intervening) [2015] 3 W.L.R. 1373.

Unfortunately the judgments in these cases are rather complex, running to over 100 pages in total. Neither case involved asset finance but the principles to be derived are the same. The first case involved a complex series of investment agreements between sophisticated parties, whilst the second case involved the rather more mundane situation of a motorist overstaying the two hours allotted as free parking in a supermarket car park. However, both cases involved the court giving detailed consideration to the principles of liquidated damages and the concept of penalties.

The leading judgment was given by Lord Neuberger of Abbotsbury PSC and Lord Sumption JSC (with whom Lord Carnwath JSC agreed), who said at paras 31-32: –

“The real question when a contractual provision is challenged as a penalty is whether it is penal, not whether it is a pre-estimate of loss. These are not natural opposites or mutually exclusive categories. A damages clause may be neither or both. The fact that the clause is not a pre-estimate of loss does not therefore, at any rate without more, mean that it is penal. To describe it as a deterrent (or, to use the Latin equivalent, in terrorem) does not add anything. A deterrent provision in a contract is simply one species of provision designed to influence the conduct of the party potentially affected. It is no different in this respect from a contractual inducement. Neither is it inherently penal or contrary to the policy of the law. The question whether it is enforceable should depend on whether the means by which the contracting party’s conduct is to be influenced are “unconscionable” or (which will usually amount to the same thing) “extravagant” by reference to some norm.

The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance”.

Lord Mance JSC said something similar at para 152:-

“What is necessary in each case is to consider, first, whether any (and if so what) legitimate business interest is served and protected by the clause, and, second, whether, assuming such an interest to exist, the provision made for the interest is nevertheless in the circumstances extravagant, exorbitant or unconscionable.”

Comment

As a result of this decision standard liquidated damages clauses used throughout the asset finance industry will be more difficult to challenge as penalties. It will normally be possible for the financier to demonstrate that such clauses are commercially justifiable in the context of its legitimate interest in holding customers to their contractual obligations to make payments throughout the life of an agreement.

However, care should still be taken to ensure that as far as possible liquidated damages clauses properly reflect the losses likely to be sustained by a financier upon termination in the event of default, and particular regard should be had to the relevance of the value of repossessed equipment which may well differ in the case of a finance lease, an operating lease and a hire purchase agreement.